Fallimento
Dicembre 2012

“Bankrupt Banks” – the Case for Special Insolvency Regimes for Bank Failures

Estremi per la citazione:

J. Crivellaro, “Bankrupt Banks” – the Case for Special Insolvency Regimes for Bank Failures, in Riv. dir. banc., dirittobancario.it, 30, 2012

ISSN: 2279–9737
Rivista di Diritto Bancario

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A seguito della crisi finanziaria del 2007-09 e del tracollo di importanti istituti creditizi sia la Gran Bretagna che gli Stati Uniti hanno riformato la normativa bancaria per introdurre un nuovo regime speciale per il fallimento bancario.

La Gran Bretagna ha adottato lo Special Resolution Regime per poter garantire una ordinata risoluzione del fallimento bancario senza dover ricorrere al sostegno statale in forma diaiuti pubblici (bail out). Allo stesso modo, il Dodd Frank Actha introdotto negli Stati Uniti un regime speciale per il fallimento di enti e società principalmente impegnate in attività finanziarie.

Entrambi i regimi compiono un importante passo in avanti nel riconoscere l’importanza di assicurare la continua operatività dei servizi bancari essenziali, evitando quindi un possibile contagio ad altri settori dell’economia attraverso l’utilizzo di strutture di sostegno temporaneo (bridge banks) o il rafforzamento della supervisione finanziaria preventiva in modo da arginare i rischi di fallimento.

Nonostante i meriti di questi due regimi, nè la normativa britannica nè quella statunitense affrontano in maniera adeguata le difficoltà di risolvere i fallimenti bancari in chiave internazionale, come venne raccomandato nelle relazioni del Basel Commitee on Banking Supervision e dell’Institute on International Finance. Il fallimento della Kaupthing Bank islandese nel 2009 ha evidenziato le debolezze insite in un approccio limitato esclusivamente al piano nazionale. Tale modus operandi comporta spesso ripercussioni negative sull’economia poichè viene sovente richiesto al paese di origine dell’istituto bancario di sostenere per intero il peso dell’intervento statale.

L’articolo si conclude con un giudizio positivo sia sulle proposte di aumentare lo scambio di informazioni fra gli enti regolatori coinvolti nel fallimento bancario sia su quelle miranti ad assicurare maggiore reciprocità e riconoscimento alle misure adotatte dalle rispettive autorità creditizie.

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The United States and the United Kingdom have responded to the recent financial crisis with an ad hoc regime for ailing banks. Title II of the Dodd-Frank Act introduced the Orderly Liquidation Authority (“OLA”)1 with special insolvency powers to assist financial institutions facing imminent bankruptcy. The United Kingdom introduced a Special Resolution Regime (“SRR”) to ensure the orderly resolution of financial institutions in the Banking Act of 2009.2 This comment considers whether, despite the enhanced powers of the national regulators, the answer to cross border bank insolvencies lies in international joint cooperation amongst the various regulating authorities rather than in territorial legislation.

The lessons drawn from the collapse of Fortis Group and Kaupthing Bank, as well as the tentative resuscitation of Dexia N.V./S.A., are instrumental in clarifying the structural limitations of a territorial resolution of failed banks. Fortis Group was split along national borders with each respective national authority (Dutch, Belgian and Luxembourgish) acquiring a costly stake.3 Dexia was assisted by a joint guarantee mechanism split among a Belgian 60.5% stake, France’s 36.5% stake and Luxembourg’s 3% stake.4 When Icelandic banking giant Kaupthing Bank was on the verge of collapsing in late 2008, the national-political implications appeared even stronger. National regulators sought to ring fence domestic assets5 and the Financial Services Authority (“FSA”) of the United Kingdom treated Kaupthing Bank as an insolvent institution regardless of the position of the Icelandic authorities.6 Similarly, in the United States the collapse of Lehman Brothers Holdings was exacerbated by the differences in the various bankruptcy regimes in which the investment bank was operating.7

The consequences of a territorial focus on the resolution of bank failures have been significant and generally detrimental to the proper functioning of the economy. Disorderly international regulation necessitates orderly domestic resolution – often entailing a public bail out by the home jurisdiction.8 This requires large expenditures of public outlays and an undesirable governmental intervention in the bank’s administration.9 Moreover, adopting a domestic lens for the resolution of bank failures ignores the economic reality of the firm’s operation. Many financial institutions have consolidated operations in the past generation forming unprecedented banking conglomerates10 while significantly increasing their international reach.11 International competitiveness has diversified corporate structures with leading financial institutions ordinarily arranged by means of a holding company and a multitude of subsidiaries and affiliates.12 Against this background, the regulatory framework has “failed to integrate regulation, supervision and resolution as thoroughly as the private sector has integrated its operations globally.”13 For regulators to insist on domestic characterization of a bank’s operational structure unduly hinders the institutions’ market effectiveness. A national restriction is sub-optimal insofar as it instills arbitrary liquidity and capital requirements during ordinary banking operations,14 and decreases the premium a private party will pay to rescue the bank once sale of the ailing entity is planned.15

Traditional insolvency regimes have also failed to address the banking crisis from a purely legal perspective. Pre-Crisis regimes were burdened by extensive regulatory fragmentation and an exclusive analysis of the institution as a “legal entity” rather than as a business group composed of multiple legal personas.16 Moreover, once regulators are empowered, they are often constrained to act in the pursuit of national interests rather than global financial stability. Consequently, statutory resolutions and executive orders are themselves calibrated on a political dimension.17

The structural bias of insolvency law is so profoundly embedded that traditional bankruptcy jurisdiction jars at first sight with the objective of cross-border banking resolutions. In fact, whereas ordinary liquidation seeks to protect creditors the special features of a bank as a financer of the public economy requires the protection of financial stability as the primary concern.

Unlike the prisoner’s dilemma in game theory, for each national authority to pursue its own self-interested politics will result in a globally worse position, while for each authority to pursue a coordinated path is likely to result in a proportionately shared fiscal burden. Other significant legal impediments are the role of shareholder rights – whose ordinary operations in the corporate arena are sufficient to forestall prompt response18 – creditor rights, and constitutional protections. A pre-emptive banking resolution will require creditors to relinquish part of their claims when the debtor is still a viable entity clearly undermining the principles of contractual relationship and orthodox bankruptcy law.19

Despite the significant proposals for a universalized insolvency regime, the likelihood of its introduction is minimal. Even in the exclusive context of banking resolutions, for a regime to cater for the differing expectations of financial institutions and political electorates across the world is almost impossible.20 On the other hand, what recent academic literature and legislative amendments have highlighted is a pressing need to strengthen the regulatory and cooperative powers of national regulators.

Calls for greater information sharing began at the April 2009 Financial Stability Forumwith the publication of the Principles for Cross-Border Cooperation on Crisis Managements.21 The Principles encourage regulators to develop uniform “support tools” to respond to transnational resolutions, and urge information-sharing of matters relevant to a firm’s corporate structure as well as inter-linkages of the institution and their implications for the economy.22 The Basel Committee on Banking Supervision issued the Report and Recommendations of the Cross-border Bank Resolution Group23 proposing ten recommendations to similarly heighten the supervisory and regulatory powers of national regulators so as to avoid disorderly insolvencies or public bail outs.24 In particular, the Committee recommends granting wider powers to national authorities to deal with financial institutions at a preventive stage.25 These powers include the authority to create bridge banks, to transfer assets and liabilities to other solvent institutions, to fund ongoing operations during resolution process and to hold managers to account.26 The past financial crisis evidenced the deficiencies of the former regime insofar as certain regimes lacked the power to introduce bridge banks for non-banking institutions,27 while others lacked the legal authority to hold managers to account28 or the supervisory capabilities to adequately monitor the institution.29 The report advocates the harmonization of current insolvency regimes not by supranational (binding or non-binding) agreements, but by granting regulators substantially similar regulatory powers: a common tool box to address cross border resolutions.30 Cooperation amongst the national entities is strongly encouraged, and the introduction of compulsory Management Information Systems for cross-border sharing is advised.31 Recommendation 9 provides for the exceptional power to override the ordinary operation of early termination clauses, close out of netting and set off rights (traditionally triggered by the appointment of administrators and liquidators) so as to grant time for a complete transfer of viable contracts to another financial institution.32 An International Monetary Fund Report published later in the year advocates earlier intervention for national authorities at a standard analogous to the federal “critically undercapitalized” threshold, urging regulators to abandon the balance sheet test of the exhaustion of the bank’s net worth.33 Regulators should be granted the express power to bypass corporate formalities if it is necessary to ensure the sale to a private sector purchaser of the bank as a going concern.34 Consolidating the statutory basis for the creation of bridge banks, for the partial transfer of deposits and assets to a “toxic bank” and assisted sales (with limited financial guarantees) are also recommended.35 Moreover, the IMF Report stresses the need for restricted judicial review to ensure that an ex post facto judicial reanalysis of the resolution will not undermine the effectiveness of the transaction sought.36 Another influential source of academic criticism was launched by the Institute of International Finance in its report on Addressing Priority Issuesin Cross-Border Resolution.37 The report emphasizes the need for banks to provide for the maintenance of “critical functions” to avoid the unexpected interruption of systemic features (services which cannot be readily substituted or whose termination would have substantial spillover effects on the economy and for which users have not had the opportunity to protect themselves ex ante.)38 The bail-in is envisaged as the primary answer to bank resolutions, introducing a contractual arrangement which would expose subordinated debt holders to liability as equity holders.39 A successful bail-in allows for the orderly liquidation of the company avoiding both extensive public outlays and the systemic risks to the economy.

Federal response to the banking crisis has been encompassed in the OLA, a special insolvency regime created to address the failures of systemically important financial companies (SIFIs) in cases in which their failure would gravely impact the US economy.

While the OLA does not replace the traditional insolvency regimes, federal regulators now have the authority (and discretion) of liquidating particular institutions under this special framework. Banking holding companies and companies identified for heightened systemic risk regulation are eligible for OLA resolution.40 The latter includes companies which are predominantly engaged (over 85% of their revenue) in financial activities as well as their subsidiaries.41 Institutionally, the Act has introduced the Federal Stability Oversight Council (“FSOC”) and charged it with the task of preemptively identifying risks to financial stability before they materialize.42 Once reported to the Board of Governors the institution may be subjected to the prudential regulation of the OLA.43 Under the OLA framework, the institution is placed in Federal Deposit Insurance Corporation (“FDIC”) administered receivership44 which will seek to expeditiously resolve the bank, rather than struggle to maintain the bank as a going concern through the disbursement of public funds. Once the Treasury Secretary confirms that a failing financial institution should be liquidated, the FDIC can dispose of exceptional powers such as the authority to enforce advantageous contracts and repudiate burdensome arrangements,45 transfer assets and liabilities to a third-party acquirer or to a specially chartered bridge company.

When assessed in light of the reforms proposed by the academic and institutional authors, the federal regime adheres to the economic principles underpinning cross-border bank resolution. For example, the OLA regime addresses financial resolutions through a more holistic perspective of the banking institution than the prior regime, having extended its protection to non-banking institutions. The critically under-capitalized threshold for FDIC receivership provides a bright-line quantitative standard which confirms the goal of earlier regulatory intervention upon objective bank equity ratios.46 Moreover, the FDIC is granted considerable flexibility once operating under the OLA regime. Unlike the firmer “no creditor worse off” standard of the British SRR regime, the FDIC can treat similarly situated creditors differently, insofar as this discrimination is necessary to maximize the value of the assets, or initiate or continue essential operations of a bank.

On the other hand, unlike the centralized UK SRR regime,47 the OLA is unlikely to adequately solve issues of regulatory forbearance and fragmentation.48 The extensive inter-agency cooperation required before the OLA can be triggered may well lead to administrative delay at a time when expediency and decisive action is most necessary.49 Consequently, the OLA regime can be criticized insofar as it exacerbates regulatory complexity rather than streamlining the process and assigning the determination of banking resolutions to a single agency. When considering the added level of complexity involved in cross-border banking failures, the feasibility of effective transnational agency interaction is impeded when multiple agencies (rather than a single entity) are delegated with the authority to regulate the matter. Furthermore, explicit references to international cooperation are allusive and at most, aspirational. While the FDIC may enforce the OLA regime on foreign companies, the legal authority for this exercise of extra-territorial jurisdiction or jurisdiction over foreign financial entities located in America is inadequately defined. For example, when considering whether a foreign non-bank entity should be encompassed within the framework,the FSOC has the obligation to “consult with the appropriate home country supervisor”50 although the scope of that duty is limited “to the extent appropriate.”51 Consequently, while the FSOC may have an apparent duty to consult foreign agencies that duty is self-defined by the FSOC and carries dubious enforcement power. Similarly, while regulatory agencies are invited to conduct studies which consider the “prospects of international coordination” when establishing the wider perspectives of bank resolution,52 there is no legally binding obligation on the agencies to pay heed or deference to foreign resolutions on the matter.

Without an effective system of cross-border cooperation and information sharing, the FDIC will invariably face substantial difficulties in administering the sale to a private party or in organizing the chartered bridge bank support especially insofar as other nations have ring-fenced the bank’s assets in their respective jurisdictions.53 Greater cooperation on an international scale, including cases where it would prima facie appear to harm national interests may help achieve- globally and in the longer perspective – an economically more satisfactory result. To this end, the Swiss Regulatory Authorities have introduced provisions which mandate extensive international collaboration and the recognition of judgments of foreign regulators where three specific elements are met: 1) secured and privileged creditors are protected, 2) the measures enacted are reciprocal and 3) the treatment of creditors does not discriminate on the grounds of nationality.54

Consequently, while the global financial centers have been quick to respond to the political concerns of bank bail-outs the US regulatory response has not pursued the call for greater cooperation at a preventive international stage. Without binding commitments for entity-specific resolutions, the likelihood of territorial and retaliatory regulatory measures will exacerbate financial crisis and the systemic impacts on the economy. As literature has emphasized55 the three goals of “financial stability, cross-border banking and national financial supervision” are no longer compatible.56 The new financial trilemma proposed by Professor Schoenmaker suggests that policy makers will have to forego one of the three elements to prevent future banking crises. Given that financial stability and cross-border banking are not likely to be compromised, national financial supervision must be readjusted to a changing world of international banks. This comment argues that rather than introducing uniform rules of insolvency for banking institutions, a possible solution could be the harmonization of resolution tools and the duty to actively cooperate at the preventive stage before the crisis escalates.

1

Dodd-Frank Wall Street Reform and Consumer Protection Act, Title II, H.R. 4173, 111th Cong. (2010).


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2

The Banking Act 2009, c. 1, cl. 1 (Eng.) [hereinafter “Banking Act”].


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3

Zdenek Kudrna, Regulatory Aftermath of banking rescues: More European or business as usual? EUSA Twelfth Biennial International Conference, Boston, MA, (3-5, Mar. 2011).


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4

Barbara Jeanne Attinger, Crisis Management and Bank Resolution, Quo Vadis Europe?, European Central Bank, Legal Working Paper 13/2011, at 10.


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5

In Finland, the Rahoitustarkastus seized control of the bank’s administration to avoid the intra-group transfer of funds back to Ireland. Suomen Kaupthing jatkaa - "toistaiseksi", Kauppalehti, Oct. 09, 2008 available at http://www.kauppalehti.fi/5/i/talous/uutiset/etusivu/uutinen.jsp?oid=200..., (last visited Mar. 1, 2012). See also, Luc Laeven and Fabian Valencia, Resolution of Banking Crises:

The Good, the Bad, and the Ugly, IMF Working Paper, 2010, at 16.


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6

The Kaupthing Singer & Friedlander Limited Transfer of Certain Rights and Liabilities Order 2008 No. 2674, (Oct. 8, 2008).


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7

More than 75 separate bankruptcy proceedings were instituted following Lehman’s insolvency. Stijn Claessens, Richard J. Herring, Dirk Schoenmaker & Kimberly A. Summe, A Safer World Financial System: Improving the Resolution of Systemic Institutions 78 n. 86, Geneva Reports on the World Economy 12 (2010).


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8

In the 2007-2009 crisis the federal government directly “bailed out” Bear Stearns, AIG, Citigroup, Merrill Lynch, and Bank of America and used broader market intervention such as the Term Loan Facility, the Troubled Asset Relief Program, and unlimited insurance assistance. Viral V. Acharya, Systemic Risk and Macro-Prudential Regulation 56, New York University Stern School of Business, Center for Economic Policy Research, and National Bureau of Economic Research (Mar. 2011).


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9

See generally, Laevan & Valencia, supra note 3.


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10

For example, in the 1980s 14,000 commercial banks were operating in the U.S. with the assets of the largest five banks totaling 29% of total banking organization assets and 14% of the GDP. After an initial wave of consolidation in the 1990s, the five largest institutions now own more than 50% of the banking industry’s assets, and roughly 60% of the GDP. Thomas M. Hoenig, (former) Chief Exec. Officer of Fed. Reserve Bank of Kansas City, presented at the Pew Financial Reform Project and New York University Stern School of Business Conference, Do SIFIs Have a Future? Dodd-Frank One Year On 3 (June 27, 2011) available at http://www.kansascityfed.org/publicat/speeches/Hoenig-NYUPewConference-0... (last visited Mar. 1, 2012).


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11

Id.


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12

Richard Herring & Jacopo Carmassi, The Corporate Structure of International Financial Conglomerates: Complexity and it implications for Safety & Soundness, in Oxford Handbook of Banking 187 (Allen N. Berger, Phillip Molyneux and John Wilson eds., 2010).


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13

Id. at 212.


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14

For example requiring an institution to match its assets and liabilities on a domestic basis. F.T. Allen, E. Beck, P. Carletti, D. Lane, W. Schoenmaker & W. Wagner, Cross-Border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies, CEPR Report, London (2011).


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15

This is because the domestic regulator will only be able to offer the domestic assets of the bank and not the entire banking group’s value.


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16

For example in the United States, commercial banks were subject to the Federal Deposit Insurance Act, brokerage firms were resolved under the Securities Insurance Protection Act while all other financial firms were administered under the U.S. Bankruptcy Code. Robert R. Bliss, Resolving Large Complex Financial Organizations, in Market Discipline in Banking: Theory and Evidence 3 (George G. Kaufman ed., 2003);


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17

For instance, the TARP Assistance Program was offered exclusively to banks headquartered in the United States.


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18

Attinger, supra p. 16.


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19

Id. at 9.


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20

Legal and Monetary Capital Markets Departments of the International Monetary Fund, “The Resolution of Cross-Border Banks—A Proposed Framework for Enhanced Coordination (June 2010). Univeralism is also taken to mean the resolution by a single bankruptcy court of the assets of a multinational firm. Donald T. Trautman et al., Four Models for International Bankruptcy, 41 Am. J. Comp. L. 573, 579; Robert . Rasmussen, A New Approach to Transnational Insolvencies, 19 Mich. J. Int’l. L. 1, 16-17.


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21

Financial Stability Forum, Principles for Cross-Border Cooperation on Crisis Management (Apr. 2, 2009), available at www.financialstabilityboard.org/publications/r_0904c.pdf.


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22

Id. at 2-4. The Financial Stability Board issued a Moral Hazard Report in October 2010 highlighting the need to reduce moral hazard by ensuring that G-SIFIs be allowed to fail.Financial Stability Board, Reducing the Moral Hazard Posed by Systemically Important Financial Institutions: FSB Recommendations and Timelines (Oct. 20, 2010), www.financialstabilityboard.org/publications/r_101111a.pdf.


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23

Basel Committee on Banking Supervision, Report and Recommendations of the Cross-border Bank Resolution Group (March 2010).


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24

Id. at 3.


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25

Id. at 22 Recommendation 1.


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26

Id.


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27

The United States, Id. at 8.


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28

In Germany, the German Minister of Finance Steinbrück stated it was "unthinkable" to continue dealing with Hypo-Real Estate’s current board, but lacked the statutory power to require his resignation. Martin Čihák and ErlendNier, The Need for Special Resolution Regimes for Financial Institutions—The Case of the European Union, (Sept. 2009) at 7.


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29

Kaupthing Bank in Iceland, Id. at 22.


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30

Basel Committee on Banking Supervision, at 24-27 Recommendation 2-3.


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31

In particular, the Report highlights the need to remove statutory restrictions on information regulatory authorities may divulge to other entities without breaching duties of confidentiality. Id, at 32 Recommendation 6-7.


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32

Id at 40.


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33

Čihák & Nier, supra n 28 at 14.


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34

Id, at 16-17.


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35

Id.


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36

Id, at 17-18. See also, International Monetary Fund and the World Bank, 2009, “An Overview of the Legal, Institutional, and Regulatory Framework for Bank Insolvency,” (Washington: International Monetary Fund and the World Bank) available at www.imf.org/external/np/pp/eng/2009/041709.pdf.


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37

Institute of International Finance, Addressing Priority Issues in Cross-Border Resolution, May 2011.


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38

Id. at 15.


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39

Id. at 20-22.


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40

These are considered “financial companies” for the purposes of Dodd-Frank Wall Street Reform and Consumer Protection Act § 203(a)(1)(8). Banking holding companies are themselves defined in §2(a) of the Bank Holding Company Act 12 U.S.C. § 1841(a)(2).


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41

Dodd-Frank Wall Street Reform and Consumer Protection Act §201(a)(11)(v) defines “predominantly engaged in financial activities.” Brokers and dealers that are registered with the SEC and are members of the SIPC may also be subject to OLA. Act §203.


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42

Act § 112(a)(1)(A).


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43

Act § 113(a)(1). A recommendation by the FDIC or the Board of Governors for FDIC receivership must outline whether the company is in danger of default and assess the likelihood of a private sector work-out, the viability of a corporate bankruptcy and spillover effects on the economy. Act § 203(a)(2).


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44

At least for banks, Act § 203(a).


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45

On the other hand, once the FDIC is appointed as a receiver, qualified financial contracts such as derivatives, foreign exchange contracts and repurchase transactions can be closed out after a day has elapsed.


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46

The Special Resolution Regime adopts a discretionary model for FSA intervention.


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47

The UK Special Resolution Regime grants the Finacial Services Authority (“FSA”) the exclusive competence to monitor G-SIFIs.


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48

See Rainer Masera, Reforming Financial Systems After the Crisis: A Comparison of EU and USA, 63 PSL Quarterly Review 299, 321 (255).


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49

Jonathan M. Edwards, FDICIA v. Dodd-Frank: Unlearned Lessons about Regulatory Forbearance, 1 Harv. B. L. R. 280, 295 (2011).


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50

Act § 113(f)(3).


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51

Act §113(i) (emphasis added).


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52

See, e.g., Act § 115 (c)(1)(E) (regarding study on contingent capital requirements); Act § 217 (calling for a “Study on International Coordination Relating to Bankruptcy Process for Nonbank Financial Institutions”).


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53

Integrating Regulation, Supervision and Resolution of Systemically Important Institutions 86, in Stijn Claessens, Richard J. Herring, Dirk Schoenmaker & Kimberly A. Summe, A Safer World Financial System: Improving the Resolution of Systemic Institutions 78 n.86, Geneva Reports on the World Economy 12 (2010).


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54

Institute of International Finance, Response to Basel Committee Consultation on Cross-border Bank Resolution Related Documents, December 22, 2009 at 9.


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55

Albeit in the European context.


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56

D. Schoenmaker, The Financial Trilemma, Economics Letters,111, 57-59 (2011).


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